May 2004 - Commodity Cycle

The Commodity Cycle is Over ! – What Already ?....

…I thought this was supposed to be a super-cycle with at least another 12 months’ to go (about every 12 to 15 years, commodities experience a super-cycle in which they rally for about 18 months’ or so).

I knew it was expected that China would have to slow down, as I was in China (visiting Sino Gold’s operations) when the 7% target rate for 2004 was announced in mid March, but I did not expect it to result in dramatic falls in commodity prices or share prices to collapse by 30% or so within the following few subsequent weeks.

When the reduced target was announced, the expectation within China was that 2004’s GDP growth rate was likely to be about 9.8%, being up from the 9.1% achieved in 2003, and the March quarter y-o-y when it was later announced, was in fact 9.7% or approximately in line with previous expectations.

The expectations that China would have to slow down were based on that fact that the infrastructure was “groaning” with the workload, in the form of a difficulty to transport material to fuel the growth, insufficient power being generated to drive the growth and a looming shortage of raw materials especially if the growth rate rose about 10% per annum. All issues that were clearly anticipated to some degree and are being addressed.

The realisation that there was probably insufficient raw material to achieve the growth rate was highlighted in the reduced size of the 2008 Beijing Olympics’ US$120m “water – cube” for swimming events and replacement of some materials in the US$480m “birds-nest” main stadium due to expectations of insufficient available stainless steel in the world to build them. Beijing currently expects to spend over US$16bn on its 2008 Olympics completing all venues and infrastructure upgrades by the end of 2006, having started construction in 2003.

There have been a number of comments about power shortages in China impacting Shanghai, but the 3 Gorges hydro-power is increasing its supply, and I saw hydro-power stations being constructed in Guizhou, with others already planned to produce in about 2 years’ time from that Province. Surprisingly there appears to be little if any gas-fired power stations in China.

The main forms of transport appear to be by roads and waterways. US$2bn has already been allocated to improving the water network that moved almost 1bnt of material in 2003, but that monetary allocation is spread over a period to 2020. What is very noticeable in China (apart from the 50 to 100 cranes in most cities) is the new freeway network that appears to be being built north/south/east/west in every Province I have so far encountered. Currently a number of the main routes twist and turn or pass narrowly through villages.

These new freeways are like straight Roman roads and tunnel through mountains, or take off sides of hills, or bridge reputedly 200m or so deep gorges, whatever geographical object is in the way is passed through or across. The freeway that I passed alongside a number of times for its 200km length from Guiyang towards Sino Gold’s Jinfeng as shown in Figure 1 has bricked sides as well as a concrete “pattern” structure to channel away rainfall, and is expected to be completed by December 2004. The “plastic” covering the soil is to trap moisture and encourage plant growth. Such freeways could handle road trains to transport material, whereas current roads are not really designed for them.

China’s growth has attained a level of momentum that like a supertanker, cannot simply be suddenly stopped. It also has to be recognised that even if its growth rate did level then its annual consumption increase would still be dramatic. If anything the reduction in metal prices means that China has been able to buy its spot raw materials at lower prices than it would otherwise have had to pay.

A GDP growth rate of say 9.7% in the March quarter is an average, the actual copper imports by China in MQ04 have been estimated at about 705,000t or about 26% y-o-y, an increase from the 21% y-o-y rate that had been achieved in the first 2 months of 2004 (at a time when Japan’s copper demand increased by 14% and US demand up 9% for an increase in global copper demand of 7.6% for the first two months of 2004 according to the ICSG). The latest LME stats show copper stockpile levels as continuing to fall, they were down almost 5,000t to about 148,000t at the end of the first week in May, and are now down 64% or 282,000t from the stockpile levels they were at the end of 2003. At current rates of draw down there may be no LME stockpile of copper in July 2004. Yet copper prices are falling because China has stated that it wants to slow its growth down.

The new GFMS survey on platinum and palladium highlights a major shortage of these materials which is quite understandable given the rising levels of autocatalyst-bearing car consumption in China as wealth increases there. Despite such demand, PGE prices have also been falling along with the gold price.

It seems that the prices are being driven more by speculative hedge funds using a weight of money argument to back their current perceptions of what is expected to happen by a number of “forecasters” during the coming year, compared to the underlying fundamentals which at some stage have to “kick-in”. Hedge funds are not really fussy whether prices go up or down as long as they can make money on the movement. However, take oil for example, unleaded petrol prices in Sydney are expected to exceed A$1.00 per litre in the coming week ending 14 May as oil prices hover in the US$40/bbl vicinity due to increasing demand and consumption of oil products in China.

China’s oil demand has been forecast to exceed that of Japan in 2005 and by 2007 or so become the 2nd largest consumer of oil in the world (after the US) exceeding by then the combined oil demand of Germany, the UK, France and Denmark.

Increasing oil prices are inflationary and yet US interest rates are expected to rise to cap the growth and strengthen the US$, and so the gold price is falling. Whatever happened to the gold price rising on expectations of inflation? It is not surprising that a number of resource stock shares are weak as prices do not appear to be following fundamentals, and instead appear to be following speculative expectations of what may or may not occur to the fundamentals quite often from people who have never even visited China.

There are numerous profit examples of fundamentals being ignored in current stock prices such as Independence (IGO)‘s A$10.5m NPBT in MQ04 based on producing an attributable 1,100t of nickel, or Zimplats’ operating cashflow of US$15.2m in MQ04 on 52,000oz4EPGE, or even LionOre’s dramatic NPAT improvement from US$2.7m to US$58.1m in 2003.

Unfortunately we are heading into the stock market quiet period of the “fly away in May” followed by the Northern Hemisphere holiday season of Wimbledon and all that, ready for August when the fundamentals of the second quarter in China should have been received along with then prevailing LME stockpile levels and revised growth rates.

Disclosure and Disclaimer : This article has been written by Keith Goode, the Managing Director of Eagle Research Advisory Pty Ltd, (an independent research company) who is an Authorised Representative with Taylor Collison Ltd, and with his associates, holds interests in a number of the stocks mentioned in this article. The opinions expressed in this article should not be taken as investment advice, but are based on observations by the author. The author does not warrant the accuracy or completeness of any information and is not liable for any loss or damage suffered through any reliance on its contents.